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PFIC gifts from a NRA

This week’s newsletter topic is from an email from a reader I will call P.

What is the basis and holding period of a PFIC received from a nonresident alien as a gift?

Today’s post is a sequel to a previous post written by Debra Rudd, in which she discussed the basis and holding period of a PFIC received from a nonresident alien as an inheritance. You can read that scenario here.

PFIC defined

A passive foreign investment company (PFIC) is a foreign corporation that meets either 1 of the following 2 tests (IRC §1297(a)):

Income test: At least 75% of the corporation’s gross income is passive income.

Asset test: At least 50% of the corporation’s assets are passive assets.

Income from PFICs (whether gain or distribution) is subject to special punitive rules to discourage US persons from making passive investments abroad.

What is basis, and why do we care?

When you sell property (such as shares in a PFIC), you are taxed on the gain from the transaction. IRC §§61, 1001. The gain from the sale is the amount you received from the sale minus your basis in the property. IRC §1001(a), (b).

You want a high basis (if you can get it) because it reduces the amount of income that is subject to tax from a sale.

The recipient takes over the giver’s adjusted basis

There are no special rules for basis of PFICs received as gifts. Just as with a normal gift, the recipient simply takes over the adjusted basis in the hands of the giver. IRC §1015(a).

Under the normal rules for property received as gift, the recipient can receive an increase in basis for gift taxes paid. IRC §1015(d). However, nonresident noncitizens are not subject to gift tax for transfers of intangible assets (such as shares in a PFIC). IRC §2501(a)(2). This increase in basis rule is unlikely to apply.

The recipient’s holding period starts on the same day as the start of the giver’s holding period

Why do we care about the recipient’s holding period?

The calculation of PFIC taxes relies on the holding period of the taxpayer. Suppose the recipient sells a PFIC share. Tax on the gain is calculated as follows (IRC §1291):

The gain is allocated evenly over the recipient’s entire holding period for the PFIC.

The allocated gain is divided into 3 separate intervals: (a) the pre-PFIC period; (b) the current year; and (c) the prior year PFIC period.

Gain allocated to the pre-PFIC period and current year are included in income and taxed at ordinary rates.

Gain allocated to the prior year PFIC period is taxed at maximum rates and subject to interest charge.

It is important to know the holding period because it is used to determine how much gain is taxed at ordinary rates, how much gain is taxed at maximum rates, and how much interest charge is applied.

The recipient’s holding period starts on the same day as the start of the giver’s holding period

With 3 exceptions, the shareholder’s PFIC holding period is determined “under the general rules of the Code and regulations concerning the holding period of stock”. Prop. Treas. Reg. §.1291-1(h)(1).

The first exception relates to a situation where (1) a nonrecognition transfer where the fair market value of the PFIC is below the shareholder’s adjusted basis, and (2) the shareholder making the transfer would have been required to recognize gain under PFIC rules had FMV been above adjusted basis. Prop. Treas. Reg. §1.1291-6(b)(5).

The first exception does not apply, because nonresident aliens do not treat PFIC shares as PFICs. Reg. §1.1291-9(j)(1). The nonresident alien giver is not subject to PFIC gain recognition rules when he gives away the PFIC shares.

The other 2 exceptions are related to purging elections that a PFIC shareholder can use to stop treating shares of a foreign corporation as PFIC shares. Reg. §§1.1291-9, -10. These do not apply, because the nonresident alien giver never treated treated his shares as PFIC shares. You can read more about these purging elections here.

Under general holding period rules, when a recipient receives an asset by gift, his holding period must include the holding period of the giver. Reg. §1.1223-1(b). The recipient’s holding period starts on the same day as the start of the giver’s holding period.

The tax results are not as bad as you think

Suppose the recipient sells the shares in the PFIC. How does the holding period of the nonresident alien giver factor into the calculation? Recall that tax on the gain is calculated as follows (IRC §1291):

The gain is allocated evenly over the recipient’s entire holding period for the PFIC.

The allocated gain is divided into 3 separate intervals: (a) the pre-PFIC period; (b) the current year; and (c) the prior year PFIC period.

Gain allocated to the pre-PFIC period and current year are included in income and taxed at ordinary rates.

Gain allocated to the prior year PFIC period is taxed at maximum rates and subject to interest charge.

The tax results can be quite different, depending on whether the holding period of the nonresident alien is included in the pre-PFIC period (taxed at ordinary income rates) or the prior year PFIC period (taxed at maximum rates and subject to an interest charge). Fortunately, it is included in the pre-PFIC period. The source of this rule is in regulation section 1.1291-9(j)(1):

A corporation will not be treated as a PFIC with respect to a shareholder for those days included in the shareholder’s holding period when the shareholder, or a person whose holding period of the stock is included in the shareholder’s holding period, was not a United States person within the meaning of section 7701(a)(30). Reg. §1.1291-9(j)(1).

The recipient is required to include the nonresident alien giver’s holding period in the recipient’s holding period. For the interval from the start of the holding period to when the recipient actually received the shares, the recipient does not treat the shares as shares in a PFIC. As a result, the interval from the start of the holding period to the date of the gift is part of the pre-PFIC period.

This yields the following tax results:

The gain allocated to the current year is taxed at ordinary income rates.

The gain allocated to the interval between the start of the holding period and the date of the gift is taxed at ordinary income rates.

The rest of the gain is taxed at maximum rates and subject to an interest charge.

If the recipient sells the shares in the PFIC quickly, the results will be not quite as horrific as in the scenario in which a US person held the PFIC shares the entire time. Most of the gain is taxed at ordinary income rates–almost certainly a worse result than if the nonresident alien sold the shares and gave the US person cash but not as bad as when the US person invests in the PFIC directly.